Monday, 22 June 2009
A different kind of rally
It would be an understatement to say that global equity markets have been volatile in 2009.
After sinking sharply in January and February as economic data continued to worsen and as investors grew uncertain about policymakers' next steps in combating the credit crisis, global equities went on the rise in the next couple of months and now seem to have entered a period of uncertainty.
Is the recent rally for real, or merely a blip in a longer bear market? Does it represent the start of a new bull market? Will we see less volatility from here, or should we expect the roller coaster to continue?
Since the bear market began in earnest last September (with the collapse of Lehman Brothers marking an important inflection point), several global equity rallies have failed to take hold. In our opinion, however, the rally that started in March is different. That rally (which, from trough to peak, has resulted in global price advances of more than 30 per cent) is based on a combination of technically oversold conditions, aggressive global policy actions and a general sense that the global economic recession is moving past its period of greatest weakness.
The question now is whether the rally marks the end of the bear market, or if it merely represents a temporary bounce from oversold conditions. It would be premature to suggest that a new bull market has emerged or that we have seen the end of the see-saw patterns that have been in place since last autumn.
Nevertheless, we do believe there are several important differences between current conditions and the failed rally attempts that previously occurred. From a technical perspective, this rally has been marked by strong momentum and expanding volume on the upside, and diminishing momentum and volume on the downside. Additionally, lower quality and more cyclical areas of the market have been outperforming, as have emerging markets when compared with developed markets, trends that occur when more sustained recoveries begin.
The extent to which equities are able to continue to advance will depend largely on the degree to which the global economy is able to recover. On balance, our view is that the global economy is still in the midst of a severe and dangerous recession, but, importantly, the massive policy initiatives around the world have begun to bear some fruit. The dramatic interest rate cuts, spending increases, tax cuts, capital injections, bank rescues and plethora of new government programmes have all helped to combat ongoing credit-related deflation risks.
We believe the fourth quarter of 2008 and the first quarter of 2009 will mark the low points for economic growth. We expect a small gain in world economic growth by the third quarter of this year. We also expect to see modestly positive levels of growth in the United States at some point in the second half.
While investors have grown more optimistic in recent months in the face of some "less bad" economic news, it is important to remember that less bad is not the same as actual good news. As such, we believe the rally that started in early March may be running out of steam and that a resumption of the rally will require more solid evidence of an economic recovery.
At present, we believe equities are entering a correction phase, although we believe this correction will be marked more by sideways action and less by a sharp decline. We think it is extremely unlikely that prices will retreat back to their early-March levels, but we could see some modest near-term declines and believe that continued volatility is likely. Typically, such corrections result in a give-back of between one-third to one-half of recent gains (which, in the United States, would result in a short-term drop to between 800 and 850 for the S&P 500 Index).
Over the longer term, however, we expect improving economic conditions will help equities to rise, and we believe that stocks will outperform bonds and cash over the next 12 months.
The writer is vice chairman and global chief investment officer of equities at BlackRock
The majority of gains came from equity and FX, which added 2.2% and 2.6% respectively to the bottom line. Call options on Chinese and UK equities were once again the biggest contributors to performance, up 29% and 13.8% respectively. In FX, the portfolio was well positioned for dollar weakness with short USD and long gold holdings. However, the addition of Norwegian Government Bonds seemed premature as GBPNOK went through the 10.00 mark, falling 5% and costing the portfolio 0.5% on the month.
Rates also cost performance -0.4% as 10 year Gilt yields spiked 25 basis points during the month. On the plus side, short Treasury and index linked exposure offset losses with gains of 6.8% and 1.5% respectively.
A fall in portfolio volatility to sub 30% (currently 24%) allowed more cash to be deployed and cash now accounts for over 30% of assets, its lowest weight to date.
Friday, 19 June 2009
However, while the risk of inflation has certainly increased, fuelled by monetary stimulus and rising commodity prices, to believe that inflation is about to take off requires a large leap of faith. Inflation does not just happen, it requires a transmission mechanism - usually an increase in credit supply. Increased credit supply facilitates increased demand which drives prices higher. However, given we are in a 'credit crunch', it is unlikely that the financial system will provide the transmission mechanism necessary for inflation. Moreover, until house prices trough, there is unlikely to be a recovery in the securitisation market, and therefore credit growth.
Even when the credit taps are turned back on, there is enough spare capacity to absorb increased demand and wage inflation is being kept in check by rising unemployment. Thus, with the output gap in the US at its widest since 1982, it is unlikely that inflation will make a comeback anytime soon.
Finally, if the market is pricing in inflation prematurely, then the additional 250 basis points of risk premium investors can receive by moving out of 2 year Gilts into 10 year Gilts looks extremely attractive. Indeed, the Gilt curve hasn't been this steep since 1992!
Thursday, 18 June 2009
The improvement in economic fundamentals suggests Q1 2009 marked the point of greatest weakness. Indeed, had activity continued to fall off a cliff before long we'd be back in the Stone Age!
However, despite talk of green shoots, most economic data is still negative:
Moreover, after such a sharp and synchronised cut in output, to what extent is the improvement down to restocking as opposed to a sustained demand growth? Whilst forward looking indicators such as OECD leading indicators have ticked up, measures of actual demand such as consumer spending are still in decline. Indeed, consumer demand is unlikely to improve until unemployment and the savings rate stop rising and the supply of credit increases.
Indeed, in an interview with CNN this week, US Treasury Secretary Timothy Geithner suggested consumer demand and credit supply will remain weak for some time.
"You're going to see less credit flowing, as people go back to the point when they're living within their means. That's a healthy process for the economy... But it means that you're going to see a slower recovery than what you normally see."
So, as the G8 finance ministers noted in their communiqué this week:
"There are signs of stabilization, including a recovery of stock markets, a decline in interest rate spreads, improved business and consumer confidence, but the situation remains uncertain and significant risks remain to economic and financial stability."